The Politics Of Inflation And How It Could Impact The Utilities Sector

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Greg Bonnell: The utility sector, often seen as a defensive play in times of market uncertainty, but with rising inflation, does that still hold true? Joining us now for more on the topic, Marisa Jones, utilities credit analyst with TD Asset Management. Marisa, welcome back to the program. Great to have you back.

Marisa Jones: Thank you. It’s very nice to be back. Thanks.

Greg Bonnell: Inflation, clearly, the story of 2022. Aggressive rate hikes to try to tame that inflation, a big part of that story as well. What has the impact been on the utility space?

Marisa Jones: Yes, and I think, as most investors know, utilities are a defensive sector. But if you go beyond that, because of that, they’ve fared very well compared to the rest of either equities or fixed income that I look at. But beyond the essential nature of utilities, I think we have to look at the fact that the regulated utilities are very defensive in terms of being able to absorb higher costs.

This is because the rate regimes around the regulation actually allows the utilities to pass through rising costs. So, the rate structure should allow either higher fuel inputs, bond pricing, whether it be through interest rates, so forth like that, to be passed, ultimately, to the end consumer. And this allows the sector not only to be an essential defensive sector, it allows it to have a more defensive real return for investors.

So, I think looking forward into 2023, you may not expect the same returns or benefit versus the market, as we saw in 2022. But I think if you’re thinking as I am, and as you mentioned in your intro remarks, that we’re at least expecting an economic slowdown. Maybe it’s a recession. In that situation, I think that, for the reasons I mentioned, I think utilities will still fare well in 2023.

Greg Bonnell: As you mentioned, of course, it’s a regulated space. You were able to pass on cost increases to the consumer.

Is there a risk, as politicians hear more and more from the electorate, that they’re struggling with not only soaring inflation and consumer costs but the higher rates that are meant to combat that? It’s getting pretty tough for households.

Is there a danger that you could get political pressure on some of these utilities to say, hey, can you give these people a break?

Marisa Jones: Absolutely. And this is a few of the things I watch for my companies. So firstly, I mentioned that it is a defensive sector. However, there’s three areas that I’m watching, and one is affordability, as you mentioned. One would be energy security. And one would be sustainability, so how utilities do through the energy transition and environmental policies.

So on the affordability front, which is front and center now- we saw it in 2022, and I expect it to continue to play out – the different, whether it be the regulators or governments are playing a role in helping their populations deal with these rising costs. So what we’re starting to see is that different areas, and you’re seeing it almost in every jurisdiction I look at, the government is coming in with some sort of plans to help with affordability.

The risk is that who bears the costs of it, so whether it be the government. And we’re seeing this a lot of areas that the government is actually either giving direct monetary support to customers or to some utilities I’ve seen. This is actually a net positive that the government will say, you might have – we’re seeing this in, for example, New York. 60-day arrears are quite high. So we’re going to give the utilities some money directly for those customers who are at the lowest affordability, so help them erase their arrears. So it’s helping the customer, and it’s helping the utility manage through those kind of risks.

So, there are positives, but then the negatives, and we’ve seen a few examples where the governments or the regulator will look to ways that they can say, what can we do that the utility shares in some of these supportive measures?

Often, utilities are- and they’ve had plans before 2022, where they help their customers with affordability and with paying their bills. So there have been plans. But now what I worry about is if a regulator says, OK, well, we allow you to have a certain return, are we? Maybe instead of having a 10%, for example, maybe it should be 9.5%. So that could affect cash flows. That could affect the equity pricing for some of these utilities.

The other example is very, I would say, rare, uncommon, but where we saw in Nova Scotia where the government actually came in and jumped over the regulatory process. Nova Scotia Power was in front of its regulator with rates hearing, and the government came in and passed the legislation saying, we’re going to cap the non-fuel costs for the next two years, regardless of the outcome of the rate hearing.

And this, you can look at it from a financial perspective. It’s not necessarily a huge negative for Nova Scotia Power. It’s not negative in terms of credit metrics so much. But where it is very negative is sentiment investors, so I meant fixed income analysts.

Greg Bonnell: So, you’re hearing this from the market? Are market participants taking notice of these actions?

Marisa Jones: Oh, absolutely.

So S&P, the rating agency downgraded Nova Scotia Power two notches on the back of that, which is significant and ironically, ends up over the long run raising the debt financing cost for the utility, which ends up being borne by the rate payer, ultimately.

But also, on the equity side, definitely, equity investors invest in Emera (OTCPK:EMRAF), which holds Nova Scotia Power, and there’s a big question as to what kind of overhang is there for Emera, and could there be further political influence or disruption for the utility?

So, both sides are looking at this, and what can they do? If it actually does reduce cash flows, do they have to maybe raise equity or something like that or sell assets? There’s a potentially larger impact down the road.

Greg Bonnell: That’s fascinating stuff. Definitely things to be aware of, as an investor in this space. Also, just energy security, a huge theme for this year. We start thinking about utilities and their role in all this. How does that play into it, or is there a somewhere else problem?

Marisa Jones: No, no, no.

It’s absolutely everywhere because it’s brought home what’s going on. Geopolitics globally, especially in Europe and with the Russian invasion, is everyone is looking and saying, well, we need that security here, and whether it be in Canada, US, North America. But also, what opportunities are there for us as a producer of natural gas, for example, to export it to Europe and to other areas to reinforce security of the production.

So, we’re seeing that everywhere. What that’s doing in terms of pricing is hard to say this year, but it is an important thing that we, I think, as investors, have to look at too.

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